A clerk counts yuan and US dollar banknotes at a bank in Nantong, East China’s Jiangsu Province, on Sept. 21, 2016.

On May 26, Moody’s Investors Service downgraded China’s credit rating to A1 from Aa3, citing concerns over a slowing economy and growing debt, placing China on par with Japan, Saudi Arabia and the Czech Republic.

The rating downgrade was the first from Moody’s since 1989. Moody’s said China’s potential growth would fall in the years ahead, and the economy is increasingly reliant on policy stimulus. They predict that economy-wide debt levels will increase further, financial strength will erode, and the government’s direct debt burden relative to GDP will rise, whereas ongoing reforms may not offset such negative outcomes.

At the same time, the rating agency changed China’s outlook from “negative” to “stable.” Looking back, the country’s outlook was lowered to negative in March 2016 due to similar reasons, including a weakening of fiscal metrics, a continuing decline in foreign exchange reserves, and uncertainty over the capacity of authorities to implement the reforms needed to address imbalances.

In response, China’s finance ministry said the downgrade overstated the difficulties China’s economy faces while underestimating the government’s efforts to tackle structural reforms and overcapacity.

Moody’s subjectivity

There is no doubt that Moody’s is one of the most authoritative and professional credit rating agencies in the world, and is among the “Big Three” credit rating agencies, together with Standard & Poor’s and Fitch.

Credit rating, an indispensable factor in the development of modern financial markets, is directly associated with the market’s confidence and expectations toward common participants, nations and regional economies.

Like economic research, a credit rating has to have a preference or perspective, frame of reference, and analytical tools. Simply put, it needs to look at fundamentals and, more importantly, reach a conclusion through data and rating models. And apart from rigid software processing, all will rely on analysts’ calculations and judgment.

In other words, no matter how objective and neutral the ratings may sound, they are not independent from human bias. And when the result is delivered in an oral context, the wording and descriptions they choose will also impact people’s assessment of market confidence and risks.

Leverage ratio

Debt structure is an important driving force for economic development, but it could also be a source of systemic economic crisis. Thus, it is a crucial aspect of the economy, and it must be closely monitored.

To determine if China’s debt risks are severe enough to trigger a downgrade, we need to apply accurate data analysis.

According to the Bank for International Settlements (BIS), China’s leverage ratio stood at 255.6 percent at the end of the third quarter of 2016, lower than the average 279.2 percent of major developed countries. To be specific, the United States’ leverage ratio stood at 255.7; the United Kingdom’s, 283.1 percent; France’s, 299.9 percent; Canada’s, 301.1 percent, and Japan’s, 372.5 percent. Though China’s number is not ideal, it is relatively low among major economies.

In terms of the trends of leverage ratio, BIS data indicated that as of the end of the third quarter of 2016, the increase of leverage ratio was moderated by 2.5 percentage points in comparison with the same period in 2015, declining for the second quarter. At the same time, the quarter-on-quarter increase was down 1.3 percent from the end of last quarter, with a downward trend in three consecutive quarters.

As for China’s corporate debt level, which is considered more at risk, BIS data showed that as measured by the credit-to-GDP ratio, it fell 0.6 percentage points from the previous quarter to 166.2 percent as of the third quarter of 2016. This is the first decline in 20 quarters.

Also, the debt-to-asset ratio of major industrial companies was 56.2 percent by the end of March, down 0.7 percentage points compared with the same period last year, and the leverage ratio of enterprises on the micro level was also declining.

Possible risks

Based on the analysis above, we cannot conclude that China’s debt level is safe. Rather, we should be alarmed with some pressing issues.

In 1994, China’s credit-to-GDP ratio was 78.6 percent, and nowadays, as the second largest economy, its leverage ratio is on par with the United States.

However, GDP per capita in the United States is up to $55,900, seven times more than that of China, and the United States has already established a well-developed social welfare system.

China, on the contrary, still has more than 70 million people living in poverty. Even in Shanghai, where the economy is nearly on par with the developed world and there is less emphasis on GDP as a measure of economic performance, many people still earn less than $3,000 annually. In other words, China is a typical “not wealthy, high-debt” nation relative to the world’s major economies.

In particular, the RMB is not an international reserve currency, so China cannot radiate or transfer the cost of domestic development elsewhere. That is to say, in the event of a debt crisis, the corresponding risk will be at home.

For example, China’s shadow banking problem raises wide concerns, but foreign investors are excluded from the potential risks.

Another concern is that most of China’s net assets are in real estate. In 2016, the real estate sector accounted for one-fourth of China’s more than $10 trillion economy, higher than the US ratio before the subprime crisis.

In addition, since 2008, China’s banking balance sheet has inflated rapidly, and to cover for the build-up of credit, commercial banks started to expand off-balance-sheet financing, creating a black hole in the banking system and increasing the risk of uncertainty.

Hence, the China Banking Regulatory Commission recently launched a series of measures aimed at commercial banks’ off-balance sheet business.

Early warning capacity

History tells us that without the simultaneous improvement in the real economy, expansion of financial sector and even economic growth led by credit expansion could be destructive.

In this light, Moody’s downgrade is a sort of wake-up call for China to take substantial steps to eliminate risky elements in the economic system.

First, the credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-term trend. It is a useful early warning indicator for banking crises. As of today, China has surpassed the 10 percent level thought to present a risk to a country’s banking system

Therefore, we need to conduct a complete sweep of non-performing loans of State-owned and private enterprises, and make sure those removed from commercial banks’ balance sheets are also counted to calculate the actual non-performing loan rate.

Second, we need to maintain the instrumental rationality of currency issuance and get to the root of the real estate bubble. Governments at all levels must abstain from “real estate addiction” and overcome the lack of cooperation between central and local governments in the process of real estate regulation.

Third, given that the RMB exchange rate and internationalization are grand national strategies, we need to closely follow domestic and foreign trading agents, manage risk, and safeguard the bottom line of the $3 trillion foreign exchange reserves.

Fourth, we need to gradually phase out the debt-fueled growth model and avoid the false economic confidence credit expansion creates. The causal relationship between real and virtue economy must not be overturned. Financial sector expansion and innovation would be supplementary to entities, but they shall not play the leading role.

Finally, the enthusiasm of micro-level enterprises to embark on innovation is essential to hedge the risk of financial crisis.

In the foreseeable future, China would see a race between debt expansion and paying off loans: If the latter fails to catch up with the former, the likelihood of a debt crisis is mounting.

In conclusion, China needs to effectively change the economic growth model, deepen supply-side structural reform and make real breakthroughs in technological innovation, industrial upgrading and boosting domestic demand to put the Chinese economy onto the path of endogenous growth.

In the meantime, China must encourage the development of capital markets to provide new market platforms for enterprise financing and vigorously cultivate new market investment subjects, set up private banks, reduce the cost of financing, and then promote deep financial reform.

Zhang Yugui is a professor of economics and dean of the School of Economics and Finance at Shanghai International Studies University.